The real estate investing market is always changing; what was once a great real estate property could now be a below-average one. Similarly, the investment property that cost a real estate investor $500,000 to purchase it might be worth a lot more (or a lot less) when he decides to sell it, depending on many factors. In order to guarantee not to become one of those distressed real estate investors, you need to keep up with these changes; otherwise, you might have to face undesirable situations such as foreclosure or short sale in real estate investing. Most real estate investors are familiar with foreclosure and its consequences. Here, we’re discussing the other option real estate investor face when in distress: short sales.
What Does Short Sale in Real Estate Investing Mean?
Say you’re a distressed real estate investor selling your investment property; however, you get an offer so low that it won’t cover the total amount you owe on the mortgage, so you ask the lender to accept a less than the total amount owed on the loan. This is a short sale in real estate investing – selling real estate properties for less than the outstanding mortgage on them, which means real estate investors end up “short” on paying back to their lender.
Let’s take an example to make this real estate concept clearer. Say a real estate investor borrowed $400,000 to purchase a real estate property. Seven years later, this real estate investor is falling behind on the mortgage payments. Upon conducting comparative market analysis, the real estate investor learns that the value of the investment property has dropped, and it is now worth only $310,000.
Thus, he decides to sell the investment property and asks his lender for approval to sell it for $310,000. If the bank agrees and the investment property is sold, the bank will get back less than the full amount which the real estate investor borrowed. However, in most cases, the lender will consider the mortgage paid in full.
Short sale in real estate investing benefits both parties by allowing the bank to avoid repossessing the home in foreclosure, which is expensive and time-consuming, and by allowing real estate investors to avoid the negative credit consequences of foreclosure and the bankruptcy that sometimes accompanies it.
Foreclosure vs. Short Sale in Real Estate Investing
You might have noticed how foreclosure and short sale in real estate investing are somewhat similar. Both are financial options offered to real estate investors who are distressed borrowers: who are behind on the mortgage payments, who have real estate properties that are worth less than the outstanding mortgage, or both. In both situations, real estate investors are forced to sell the real estate property; however, the timeline and other consequences are different in each situation. Real estate investors typically opt for short sales rather than a foreclosure; here are the main differences between them:
- Short sale in real estate investing is usually initiated by the real estate investor when the value of the real estate properties drops by 20% or more. Before the process begins, the lender holding the mortgage, typically a bank, must approve the decision to execute short sales. Moreover, the bank needs documentation that explains why a short sale makes sense; after all, it could lose a lot of money in the process.
- If approved for short sale, the real estate buyer first negotiates with the real estate seller and then seeks approval on the purchase from the bank. No short sale in real estate investing can be executed without lender approval because it is the lender (not the seller) who will be taking a loss on the investment property.
- Short sales tend to be lengthy and paperwork-intensive transactions, sometimes taking up to a full year to process. However, they are not as damaging to real estate investors’ credit rating as a foreclosure is. To future lenders and creditors, short sales look better as they show that the real estate investor took action before the bank had to repossess the investment property. A real estate investor who has gone through a short sale may even be qualified to purchase another real estate property immediately in certain situations.
- Unlike short sale in real estate investing, foreclosures are initiated by the lender only. In this case, the lender seizes the real estate property after the borrower fails to make the mortgage payments and forces the sale of the real estate property to make good on its initial investment of the mortgage.
- Once the lender has access to the real estate property, it orders its own appraisal and proceeds with trying to sell the investment property. Normally, foreclosures do not take as long to complete as a short sale in real estate investing because the lender is concerned with liquidating the asset quickly.
- In most circumstances, real estate investors who experience foreclosure must wait a minimum of five years to buy other real estate properties, and the foreclosure is kept on their credit report for seven years. Due to foreclosure, real estate investors’ FICO score will drop by over 100 points, which might seem like a fairly small amount for a default; nonetheless, it is enough to make credit card companies consider credit limit decreases and rate hikes.
The Process of Short Sale in Real Estate Investing
The short sale process varies from state to state, but in general, the steps are:
- The real estate seller submits a financial package to the lender including financial statements, a letter describing his/her hardship, and copies of financial records.
- If the real estate seller accepts a real estate buyer’s offer, the listing agent sends the lender the listing agreement, an executed purchase offer, the buyer’s pre-approval letter, a copy of the earnest money check, and the seller’s short sale package.
- The bank reviews the offer and either approves or denies the short sale transaction. It can take several weeks to months for real estate investors to get the final response from the bank.
In some ways, buying a short sale property is just like a traditional purchase of real estate properties. However, as mentioned earlier, a short sale in real estate investing is subject to the mortgage lender’s approval, while in traditional real estate transactions, the only party who would need to approve the sale is the real estate seller (the owner of the investment property).
Considerations for a Short Sale Real Estate Buyer
Short Sales Are a Waiting Game
Short sale transactions in real estate can be much more time-consuming than regular real estate transactions. Why? Because banks often won’t approve short sales without real estate buyers agreeing to its demands like paying for all repairs and closing costs. Thus, real estate investors making an offer on a short sale in real estate investing need to be prepared to wait.
The Real Estate Seller Must Be in Official Default
The lender may not approve short sales if the real estate seller of the real estate property has not officially gone into default yet. It would take a considerable amount of time to get the bank’s approval to a short sale;thus if it hasn’t already agreed, don’t waste your time.
Contact Experienced Agents
Due to the complexity of this process, the real estate buyer needs to make sure that his/her agent or realtor is experienced with short sales. Some real estate agents are specialized in short sales and hold a Short Sales and Foreclosure Resource (SFR) certification.
A short sale real estate buyer also has to keep in mind that not all real estate agents are willing to work with short sales. This is because short sales not only require more work but also sometimes offer less compensation: the bank may not be willing to pay the real estate agent the usual 5% commission because it is already taking a loss.
Negotiating Over Prices
For real estate investors to increase the odds of the bank approving a short sale in real estate investing, they may try to convince you, as a short sale real estate buyer, to raise up your purchase price, so be prepared for negotiations.
Keep Searching for Other Opportunities
Seeing how long the bank will probably take to reply to your offer, you should keep looking at other real estate properties while you wait for a response. If you found an easier deal, it is probably best to proceed with the purchase of the other real estate property.
The Pros and Cons of Short Sale in Real Estate Investing
For the seller, the most significant advantage of a short sale in real estate investing is that he/she can avoid foreclosure. As previously mentioned, with a foreclosure in your credit history, you’re going to have to wait at least seven years before another lender will even consider you for a mortgage. On the other hand, when it comes to short sales, real estate investors only have to wait as little as two years and sometimes are even allowed to buy another real estate property right after selling.
The biggest advantage for the real estate buyer is obviously the opportunity to buy real estate properties which they might not be able to afford otherwise at a price below the fair market value.
As for the disadvantages, the first one is time. Short sale in real estate investing takes much longer than a traditional sale because the mortgage lender has to agree on the process first. Even if all of the paperwork is in order and the real estate seller and real estate buyer both agree on a price, there would still be no guarantee that the lender will approve the real estate transaction. Both the real estate seller and the real estate buyer need to prepare themselves for a long and uncertain process that could end in disappointment.
For the real estate buyer, another potential disadvantage is higher closing costs. In a traditional real estate transaction, the real estate seller is responsible for paying for the investment property inspection and any related repairs. As for short sale in real estate investing, however, the real estate seller is already short on the mortgage payment, and the bank is unlikely to make any repairs or pay for closing costs; thus the real estate buyer often has to take on these costs.
The Bottom Line
Short sale in real estate investing can benefit all the parties involved: lenders avoid the costly process of a foreclosure, real estate sellers keep foreclosures off their credit reports, and real estate buyers may have the chance to purchase real estate properties at lower prices. A real estate buyer should not, however, assume that the real estate property is a great deal just because it is a short sale. Therefore, as a real estate buyer, make sure to do your own comparative market analysis. Start your trial with Mashvisor to get access to numerous tools that successful real estate investors use, such as Mashvisor’s investment property calculator, investment property finder, investment property analysis, and many more.